MONETARY POLICY IN INDIA

Transcription

1 228 MONETARY POLICY IN INDIA "The first and most important lesson that history teaches about what monetary policy can do - and it is a lesson of most profound importance - is that monetary policy can prevent itself from being a major source of economic disturbance... provide a stable background for the economy... and contribute to offsetting major disturbances in the economic system arising from other sources". - Milton Friedman : Introduction Monetary Policy is an arm of Public Policy. 2 It is a process by which the government, central bank or monetary authority manage the supply of money or trading in foreign exchange markets. It rests on the relationship between the rates of interest in an economy that is the price at which money can be borrowed and the total supply of money. 3 It, thus, has set objectives and priorities, which are derived from the respective mandates of central banks. It ranges from a single objective of price stability considered to be the dominant objective of monetary policy, to multiple objectives that also include growth and financial stability. Monetary Policy is an important aspect of overall economic policy. 4 An appropriate monetary policy contributes to economic growth by adjusting money supply to the needs of growth, by directing the flow of funds in the required channels and by providing institutional facilities for credit in specific fields of economic activities. In this way, monetary policy helps a healthy growth of the economy. Monetary Policy consists of the measures taken by the central banking authority to regulate the cost and availability of credit. Monetary and credit policy operate through five interrelated factors; (i) the availability of credit, (ii) the volume of money, (iii) the cost of borrowing, (iv) the prices of capital assets and (v) the general liquidity of the economy. 5 One of the fundamental tasks of monetary authorities in 1 Friedman Milton (1969), The Quantity Theory of Money: A Restatement, Macmillan, London, pp Mohanty Deepak (2011), "Changing Contours of Monetary Policy in India", Speech delivered at the Royal Monetary Authority of Bhutan, Thimpu, December, 1. p.1 3 Monetary Policy, 4 Jacobson, Per (1958), Some Monetary Problems, International and National, Oxford University Press, p Desai V R Muthalik (1969), Monetary Policy and Central Banking in India, Bombay Popular Prakashan, First Ed., p.145.

2 229 the growth context remains the creation of conditions for the effective mobilisation of the supply of actual and potential savings through the promotion of financial intermediaries and the creation of a spectrum of financial assets on the one hand and on the other the effective investment of these resources through the adaptation of the credit structure to sub-serve the needs of development : Definition Monetary Policy has been defined differently by various economists. According to Paul Einzig, "Monetary Policy includes all monetary decisions and measures irrespective of whether their aims are monetary or non-monetary and all non-monetary decisions and measures that aim at affecting the monetary system". 7 Harry Johnson (1963) defines monetary policy as, "policy employing central banks control of the supply of money as an instrument for achieving the objectives of general economic policy". 8 According.D Jha, "Monetary Policy is one important segment of an overall financial policy which has to be operated in the overall milieu prevailing in the country". 9 Reserve Bank of India considers monetary policy for the use of instruments within the control of central bank to influence the level of aggregate demand for goods and services. Central banking instruments of control operate through varying the cost and availability of credit, those producing desired changes in the asset pattern of credit institutions primarily the commercial banks. Thus, RBI is relatively more explicit in defining the monetary policy : The History of Monetary Policy Monetary Policy is as old as monetary system or as money itself. It has a long and chequered history since the days of mercantilism. Evidence proves the existence of monetary management in Greece. But before 1914, the whole thinking about monetary policy was based upon the idea of automatic gold exchange system. After World War I, the gold exchange standard collapsed and it is then the modern genesis 6 Bhattacharya P C (1966), "Monetary Policy and Economic Development. In 50 Years of Central Banking", Governors Speak, Mumbai, Reserve Bank of India, 1997, p.2. 7 Einzing Paul (1964), Monetary Policy - Ends and Means, Penguin Books Ltd. Harmonds Worth, Middlesex, England. p Johnson Harry G (1963), "Recent Developments in Monetary Theory", Indian Economic Review, Feb. Vol.6, No.3, pp Krishna Kumar Sharma (1968), Indian Monetary Policy, Meenakshi Prakashan, Meerut, India, p Reserve Bank of India, RBI Publications, Various years ( ).

3 230 of monetary policy took place. The 1920s inflation in Germany, and the two international conferences, one in Brussels in 1920 and the other one in Geneva in 1922, compelled the thinking about a new monetary system. The depression of the 1930s provided further stimulus to the thinking of reforms in the field of monetary management. The horizon of monetary policy has greatly widened in the recent past. The origin of monetary management in India can be traced back to time immemorial. The reference about the Panis, the moneylenders of Southern India, in Rig Veda is an evidence of the developed state of banking or credit system in the vedic age, although the date of the origin of the coins and credit instruments is lost in the midst of antiquity. In the Mauryan era, the system of currency, credit and coinage was fully developed. Kautilya devotes a chapter in his classical book the Arthashastra on rules for mining and credit. The history of monetary management and policy in terms of central banking practices in India can be traced to as far back as January 1773, when Lord Hastings, the then Governor, and later on, the first Governor General of British India, placed before the Board of Revenue his plan for General Bank in Bengal and Bihar. The Royal Commission on Indian Finance and Currency also known as the Chamberlain Commission was set up in 1913 with J M Keynes as one of the members who prepared a blueprint for the establishment of an Imperial Bank of India. 11 The bank came into existence on January 1921 by amalgamating the three presidency banks as a commercial bank with some of the functions of the central bank also. In August 1925, the Royal Commission on Indian Currency and Finance also referred the Hilton Young Commission was appointed. The Commission observed that India was the only big trading country in which the currency and note issues were under direct government control. It recommended several measures to reform the monetary system. With the recommendations of the Young Commission (1925) 12 and the Central Banking Enquiry Committee (1931), the Reserve Bank of India was established through Reserve Bank of India Act, Reserve Bank of India, 12 Reserve Bank of India, 13 Reserve Bank of India,

4 231 However, with a strong background of monetary changes, the monetary policy assumed importance since the early seventies, when strong inflationary pressures began building up in the economy. In December 1982, a committee under the chairmanship of Sukhamoy Chakravarty was appointed to undertake a review of the working of the monetary system and suggest measures for improving the effectiveness of monetary policy as an instrument for promoting the basic objectives of planned economic development. The committee made a detailed study about monetary management and made path-breaking recommendations. There were further many committees and working groups constituted to study the functioning of the financial sector and to recommend changes. The prominent among them were Narasimham Committee I and II, Tarapore Committee on Capital Account Convertibility, the Verma Committee on Restructuring of Weak Banks and the Advisory Group on Transparency in Monetary and Financial Policies. The committees have changed the way monetary policy functions : Objectives of Monetary Policy in India The changing economic priorities and views have led to changes in monetary policy. Hence, the focus is on demarking the objectives of monetary policy, this has gained further significance in the context of the increasing stress on autonomy of the central bank. Thus, the main objectives or goals of monetary policy are: 1. Price Stability 2. Economic Growth 3. Full Employment and 4. Maintenance of Balance of Payments Equilibrium The relative emphasis on any one of the objectives is governed by the prevailing circumstances. 1. Price Stability This has been a dominant objective of monetary policy. Fluctuations in the prices bring uncertainty and instability to the economy. Rising and falling prices are both not desirable because they bring unnecessary loss to some and undue advantage 14 Vijayaragavan Iyengar G (2007) Introduction to Banking, Excel Books, New Delhi, Chapter 1,2,3.

5 232 to others. Therefore, in this context monetary policy has assumed paramount importance. It aims at preventing maladjustments, that is, at eliminating the causes of recession. To achieve this, investment finance has to be regulated through appropriate variations in the rate of interest in the capital market. Rate of interest is a vital link that connects the volume of money and investment in a given economy. A Policy of price stability keeps the value of money stable, eliminates cyclical fluctuations, brings economic stability, helps in reducing inequalities of income and wealth, secures social justice and promotes economic welfare. However, there are certain difficulties in pursuing a policy of stable price level. The problem is deciding the type of price level to be stabilised. There is no specific criterion with regard to the choice of a price level. Innovations may reduce the cost of production but a policy of stable prices may bring larger profits to producers at the cost of consumers and wage earners. Again, in an open economy which imports raw materials and other intermediate products at high prices, the cost of production of domestic goods will be high. Thus, a policy of stable prices will reduce profits and retard further investment. Under these circumstances, a policy of stable prices is not only inequitable but also conflicts with economic growth. Therefore, price stability means stability of some appropriate price index in the sense that we can detect no definite upward trend in the index after making proper allowance for the upward bias inherent in all price index. Price stability can be maintained by following a counter-cyclical monetary policy, that is easy monetary policy during a recession and a dear monetary policy during a boom. In a nutshell, both inflation and deflation need to be regulated appropriately by the central bank. 2. Economic Growth This objective of monetary policy has acquired considerable significance in recent years. Economic growth is defined as the process whereby the real per capita income of the country increases over a long period of time. Monetary policy can lead to economic growth, by having a control on the interest rate which is inversely related to investment. By following an easy credit policy and lowering interest rates, the level of investment can be raised which promotes economic growth. Monetary policy also contributes towards growth by helping in maintaining the stability of income and

6 233 prices. By moderating economic fluctuations and avoiding depression, monetary policy helps in achieving the growth objective. Because fluctuations in the rates of inflation have an adverse impact on growth and monetary policy also helps in controlling hyperinflation. Moreover, tight monetary policy affects small firms more in comparison to large firms, and higher interest rates have greater impact on small investments in comparison to large industrial investment. So, monetary policy needs to be formulated in the way that it may encourage investment and simultaneously control inflation in order to enhance growth and put a control on economic fluctuations. 3. Full Employment Full-Employment is the ultimate objective of monetary policy. According to Keynes, "full employment means the absence of involuntary unemployment". 15 That is full employment is a situation in which everybody who is willing to work and able to work gets work and achieves this, Keynes advocated increase in effective demand. Burner (1961) considers "full employment is a situation where all qualified persons who want jobs at current wage rate, find full time jobs" Balance of Payments Equilibrium This objective of monetary policy has emerged since the 1950s. The emergence of this objective is due to the phenomenal growth in global trade as against the growth of international liquidity. A deficit in the balance of payments is said to retard the attainment of other objectives as it reflects excessive money supply in the economy. As a result, people exchange their excess money holdings for foreign goods and securities. Under a system of fixed exchange rates, the central bank will have to sell foreign exchange reserves and buy the domestic currency for eliminating excess supply of domestic currency. This is how equilibrium will be restored in the balance of payments. If the money supply is below the existing demand for money at the given exchange rate, there will be a surplus in the balance of payments. Consequently, people acquire the domestic currency by selling goods and securities to foreigners. 15 Keynes John Maynard (1937), "The Ex-Ante Theory of the Rate of Interest", Economic Journal, pp Burner Karl (1961), "Some Major Problems in Monetary Theory", American Economic Association, Papers and Proceedings, Vol. 51(b), p

7 234 They will also seek to acquire additional money balances by restricting their expenditure relatively to their income. The central bank, on its part, will buy excess foreign currency in exchange for domestic currency in order to eliminate the shortage of domestic currency. The Sukhamoy Chakravarti Committee 17 was appointed in 1982 to review the working of monetary system. The committee submitted a comprehensive report on the objectives in 1985, defining the role of monetary policy thus: i. Mobilisation of savings of the community and enlargement of the financial savings pool. ii. Promoting efficiency in the allocation of the savings of the community to comparatively more productive purposes in accordance with the national economic goals. iii. Enabling the resource needs of major enterprises in the country. iv. Promoting price stability. v. Promoting an efficient payment system. 7.5: Targets and Indicators of Monetary Policy The choice of targets and indicators of monetary policy are based on the objectives of monetary policy. There are three targets of monetary policy; money supply, availability of credit and interest rates. The central bank cannot directly control output prices, hence it selects the growth rate of money supply as an intermediate target. Friedman suggests that the money supply should be allowed to grow steadily at the rate of 3 to 4% per annum for a smooth growth of the economy and to avoid inflationary and recessionary tendencies. The availability of credit, and interest rates are the other two target variables of monetary policy. They are often referred to as the "money market conditions". The monetary authority can influence the short-term interest rates. It can change credit conditions and affect economic activity by rationing of credit or other means. The central bank influences economic activity by following an easy or expansionary monetary policy through reducing short-term interest rates and a tight or contractionary monetary policy through rising short-term interest rates. 17 Sukhamoy Chakravarty (1985) Report of the Committee to Review the Working of the Monetary System p

8 235 Money supply and interest rate are intermediate targets of monetary policy. They are also the competing targets, as the central bank faces a trade off as it can aim either at increasing the money supply or maintaining a level of interest rate. By targeting money interest rate it would be neglecting money supply. The general consensus of economists and policy makers is towards money supply as it is measurable, while there are a variety of interest rates. The money supply linkage with nominal GNP is more direct and predictable than the interest linkage with nominal GNP of the nation. 7.6: Instruments of Monetary Policy in India There are several direct and indirect instruments that are used in the implementation of monetary policy. 18 Cash Reserve Ratio (CRR): The share of net demand and time liabilities deposits that banks must maintain as cash balance with the Reserve Bank of India. Statutory Liquidity Ratio (SLR): The share of net demand and time liabilities deposits that banks must maintain in safe and liquid assets, such as, government securities, cash and gold. Changes in SLR often influence the availability of resources in the banking system for lending to the private sector. Refinance Facilities: The sector-specific refinance facilities aim at achieving sector specific objectives through provision of liquidity at a cost linked to the policy repo rate. The Reserve Bank has, however, been progressively deemphasising sector specific policies as they interfere with the transmission mechanism. Liquidity Adjustment Facility (LAF): This consists of overnight and term repo/reverse repo auctions. The RBI has progressively increased the proportion of liquidity injected in the LAF through term-repos. Term Repos: The term repos are introduced by the RBI since October They are of different tenors (such as 7/14/28 days). They are used to inject liquidity over a period that is longer than overnight. The aim of term repo is to help develop inter-bank money market, which in turn, can set market based 18

9 236 benchmarks for pricing of loans and deposits, and through that improve transmission of monetary policy. Marginal Standing Facility (MSF): A facility under which scheduled commercial banks can borrow additional amount of overnight money from the Reserve Bank by dipping into their SLR portfolio up to a limit (currently two percent of their net demand and time liabilities deposits ) at a penal rate of interest (currently 100 basis points above the repo rate). This provides a safety valve against unanticipated liquidity shocks to the banking system. MSF rate and reverse repo rate determine the corridor for the daily movement in short-term money market interest rates. Open Market Operations (OMOs): These include both, outright purchase or sale of government securities (for injection /absorption of liquidity). Bank Rate: It is the rate at which the RBI is ready to buy or rediscount bills of exchange or other commercial papers of commercial banks. This rate has been aligned to the MSF rate and, therefore, changes automatically as and when the MSF rate changes alongside policy repo rate changes. Market Stabilisation Scheme (MSS): The instrument for monetary management was introduced in Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through sale of short-dated government securities and treasury bills. The mobilised cash is held in a separate government account with the RBI. The instrument thus has features of both SLR and CRR. The Reserve Bank of India seeks to influence monetary conditions through management of Liquidity by operating in varied instruments. Since 1991, the market environment has been deregulated and liberalised where in the interest rates are largely determined by the market forces. The Trends in the instrument of monetary policy are shown in the Table-7.1.

10 237 Table-7. 1 : Movement in Key Policy Rates and Reserve Requirements in India (in %) Effective Since Bank Rate Reverse Repo Cash Reserve Statutory Repo Rate Rate Ratio Liquidity Ratio June October April August March 31, September 18, October 2, October 27, April 29, October 26, January 24, June 9, July 25, October 31, December 23, January 6, January 31, February 17, March 3, March 30, April 14, April August 4, November 10, April 26, May 10, May 24, June 11, July 5, July 19, July 30, August 30, October 11, March 5, April 21, November 7, February 13, March 19, April 24, July 2, July 27, Actual Source: RBI, Annual Reports. Source: Bharati V. Pathak (2012), The Indian Financial System: Markets, Institutions and Services, Third Edition, Pearson Publication, Delhi, p.86.

11 238 Table-7.2: Financial and Monetary Policy Reforms to Non-Bank Financial Institutions interest rates deregulated Risk-asset ratio introduced for banks (capital adequacy measure); lending rates structure simplified to 6 to 4 categories; reduction in Minimum Lending Rate (MLR) for large loans; treasury bill auctions introduced substantial liberalisation of bank branch licensing; capital market restrictions removed on pricing and issues of capital Reductions in Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR); lending rates structure simplified from 4 to 3 categories further reduction in MLR for large loans private shareholding in state banks allowed CRR increased; SLR further reduced MLR on large loans abolished line of rural credit increased by 11%; credit priority housing loan limit raised from 3 to 5 lakh, board of financial supervision set up CRR reduced 4 new private sector banks; more freedom for cooperative banks to set interest rates Selective credit controls on essential commodities lifted; Banks are free to set deposit rates on term deposits greater than one year ceiling on city housing loans raised 3.3 times to 10 lakh; banks determine own margins for loans against deposits; 6 new private banks Banks allowed to raise capital up to 49% from the public Greater flexibility for banks in lending and deposit rates Banks can engage in interest rate swaps for own balance sheet management 35 NBFIs allowed to borrow money through repos on a par with banks Greater freedom in trading of government securities State government stock auctions began First-ever price based auction of government securities Foreign banks are free to repatriate profits without prior approval of RBI Banks allowed to enter credit card business without prior approval of RBI Banks allowed more freedom to move/close rural branches Minimum capital to risk weighted assets ratio increased to 9% Stock exchanges allowed to extend trading terminals day treasury bills re-introduced Further reductions in CRR Cut in bank savings deposit rate Liquidity adjustment facility introduced using reverse repo and repo auctions Scope of money market instruments widened Further liberalisation of bank interest rate setting 17 public sector banks given autonomous status Risk management guidelines issued to banks Rural infrastructure fund set up to channel bank lending shortfall to priority sectors The bank rate was reduced from 7.5 per cent to 7.0 per cent RBI lowered the CRR by 50 basis points to 8% in two stages of 0.25 % points. RBI announced introduction of an Interim Liquidity Adjustment Facility (ILAF) through repos and lending against collateral of government 35 non-bank entities along with those non-bank entities which were earlier allowed to undertake reverse repo were permitted both to lend and borrow through repo transactions.

12 Bank Rate was reduced by 0.50 percentage point from 7 per cent to 6.50 per cent with effect from the close of business on October 23 rd, CRR was rationalised through (a) reduction by 200 basis points from 7.50 per cent to 5.50 per cent and (b) withdrawal of exemptions on all liabilities excepts inter-bank for the computation of Net Demand and Time Liabilities (NDRL) for the purpose of maintenance of CRR. The repo rate was cut by 25 basis points to 6.5 per cent on May 28 th, Bank rate was reduced by 25 basis points to 6.25 per cent with effect from close of business on October 30 th, 2002 With a view to provide flexibility to banks in choosing an optimum strategy of holding reserves depending upon their intra-period cash flows, the requirements of daily maintenance of minimum 80 per cent of the CRR balances was reduced to 70 per cent with effect from December The LAF repo rate was reduced to 5 per cent from 5.5 per cent effective from March 3 rd, Bank rate was reduced by 0.25 percentage points to 6.0 per cent with effect from the close of business on April 29 th, 2003, with a policy bias to keep it stable until the mid-term review of October CRR was reduced by 0.25 percentage points from 4.75 per cent to 4.50 per cent with effect from fortnight beginning June 14 th, Following the recommendations of Narasimham Committee II, RBI widened the repo market permitting the non-bank participants maintaining current SGL accounts with RBI to under both repos and reverse repos. The multiplicity of rates at which liquidity is absorbed/injected was rationalised. The revised LAF scheme was executed and reverse repo rate reduced to 6 % Bank rate was kept unchanged at 6 per cent. CRR was increased by one-half of one percentage points of Net Demand and Time Liabilities (NDTL) in two stages per cent effective from September 18th, 2004 and 5 per cent effective from October 2 nd, Repo rate was increased 25 basis points to 4.75 per cent effective from October 27 th, 2004, consistent with international usage. It indicated injection of liquidity and would be 6 per cent. Entire export credit refinance was made available at reverse repo rate. The fixed reverse repo rate was revised to 4.75 per cent An electronic trading platform for conduct of market repo operations in government securities, in addition to the existing voice based system, was to be facilitated. The fixed repo rate increased by 25 basis points to 6.5 per cent on January 24 th, The fixed reverse repo rate increased by 25 basis points to 5.50 per cent, effective January 24 th, CRR was raised by 50 basis points in two stages (25 basis points each), from February 17 th, 2007 (to 5.75 per cent) and March 3 rd, 2007 (to 6 per cent). Fixed repo rate under the LAF increased by 25 basis points to 7.75 per cent on March 30 th, All scheduled commercial banks excepting Regional Rural Banks were directed to increase the CRR by 50 basis points to 7.5 per cent of their NDTL with effect from November All scheduled commercial banks excluding RRBs and local area banks were allowed to invest in unrated bonds of companies engaged in infrastructure activities within the ceiling of 10 per cent for unlisted non-slr securities to encourage the flow of credit to infrastructure sector. Fixed repo rate under the LAF kept unchanged at 7.75 per cent during the year. Fixed reverse repo rate under the LAF was kept unchanged at 6 per cent. 239

13 CRR was kept unchanged at 5 per cent on March 4 th, Liquidity support under the LAF through relaxation in the maintenance of SLR to the extent of 1.5 per cent of their NDTL for the purpose of meeting the funding requirements of NBFCs, MFs and HFCs, which was available up to March 31 st, 2009, was extended to June The repo rate under the LAF was reduced by 50 basis points from 5.5 per cent to 5 per cent with effect from March 5 th, The reverse repo rate under the LAF was reduced by 50 basis points from 4 per cent to 3.5 per cent with effect from March 5 th, CRR was further increased to 5.75 per cent on February These were to control inflation. SLR was increased by 100 basis points to 25 per cent from 24 per cent. Repo rate was increased 25 basis points to 5 per cent on March 19 th, Reverse repo rate was increase to 3.5 per cent on March 19 th, Effective from April 24 th, 2010, CRR was increased by 25 basis points to 6 % Repo rate under LAF was further increased to 5.75 per cent with effect from July 27 th, The reverse repo rate was further increased by 50 basis points to 4.5 per cent, effective from July 27 th, Source: From to complied from Lawarence and Longjam (2003) 19, p.5 and from to , 7.7: Process of Monetary Policy Formulation in India The process of monetary policy formulation in India had largely been internal with only the end product of actions being made public. The process has overtime become more consultative, participative and articulate with external orientation. The process has now been re-engineered to focus on technical analysis, coordination, horizontal management and more market orientation. The process entails a wide range of inputs involving the internal staff, market participants, academics, financial market experts and Reserve Bank's Board as depicted in the Chart-7.(i). 7.8: Implementation of Monetary Policy in India Greater information on the dissemination and policy communication could lead to better policy outcome. For example, the US Federal Reserve, since 1994, appears to have been providing forward guidance, while the European Central Bank appears to be in the mould of keeping the markets informed rather than guiding it. In India, a middle path is followed by sharing of both information and analysis Lawrence Peter and Ibotombi Longjam, (2003) Financial Liberalisation in India: Measuring Relative Progress, Department of Economics, Keele University, p Mohanty Deepak (2010) "Implementation of Monetary Policy in India", Speech Delivered at the Banker's Club, Bhubaneshwar, 15 th March, p.7

14 241 Chart-7.(i): Processes of Monetary Policy Formulation in India Monetary Policy A consultative and participative process Central Board of Directors: Reviews the stance of monetary policy Committee of the Board meets weekly to review the monetary, economic, financial conditions and advice appropriately Internal Work Processes Technical analysis, coordination, horizontal management Periodic consultations with the Government, mainly Ministry of Finance, to ensure coordination Resource management discussions with select major banks Periodic consultations with academics and markets Technical Advisory Committees on Monetary Policy: Advises on the stance of monetary policy Board for Financial Supervision: reviews supervisory data and financial stability issues Monetary Policy Strategy Meetings Analyses strategies on an ongoing basis; reviews growth and inflation situation and macroeconomic projections Market information, economic and statistical analysis Financial Markets Committee Reviews and manages daily market operations and adopts strategies Source: Op.cit, Mohanty Deepak (2010), p.8 The stance of monetary policy and the rationale are communicated to the public in a variety of ways, the most important being the Governor's quarterly monetary policy statements. Further, the policy measures are analysed in various statutory and non-statutory publications, speeches and press releases. Information on areas relating to the economy, banking and financial sector is released with stringent standards of quality and timelines. Dissemination of information takes place through several channels. The Reserve Bank has also developed a real time database on the Indian economy, which is available to the public through its website. The explained procedure has been presented in Chart-7.(ii).

15 242 Chart-7.(ii): Information Dissemination and Monetary Policy Communication Monetary Policy Stance Governor's Policy Statements Governor's Press Meetings Speeches by the Top Management Press Releases Mode of Communication to the Public Policy Research and Analysis Quarterly Macroeconomic and Monetary Development Annual Report Annual Report on Banking Report on Currency and Finance Annual Study on State Finance Occasional Papers/ Staff Studies/ Development Research Group Studies Analytical studies in the RBI Bulletin Macroeconomic and Financial Data and Information Source: Mohanty Deepak (2010) "Implementation of Monetary Policy in India", Speech Delivered at the Banker's Club, Bhubaneshwar, 15 th March, p.7 Daily release of data on financial markets and monetary policy operations on the RBI website Weekly Statistical Supplement RBI Monthly Bulletin Forward looking Surveys Handbook of Statistics on the Indian Economy Database on the Indian Economy National Statistical Data Page

16 : Relationship between Financial Development and Monetary Policy Monetary policy has to be viewed as a means to an end and not an end in itself. The proper type of monetary policy in relation to financial development has to help the process of development by adjusting money supply to the requirements of growth, by directing flow of funds, by channelising non-activated and hoarded funds into productive institutional facilities for credit in specific fields of economic activities. The objective and scope of monetary policy are conditioned by the facts of economic situation and the changes taking place in the economic environment. Therefore, the Radcliffe Committee has aptly remarked that monetary policy is, in most cases, moulded by the world in which it takes shape. 21 The fundamental mechanism behind the effectiveness of monetary policy is at the centre of debate. At the theoretical level, the monetary approach stresses the liquidity channel that is an increase in money supply reduces interest rates, which in turn affects private spending. An alternative approach stresses a credit channel, as per this, a change in the monetary condition affects not only the "price of liquidity" or short-term interest rate, but also the conditions at which credit is allocated among the sub-sectors in the economy. An important part of the empirical literature on monetary policy, effectiveness is concerned with the predominance of one channel over the other. However, since both channels operate through the financial system, the degree of financial development appears crucial in explaining monetary policy effectiveness. As the financial system develops, the relative power of one channel as monetary policy transmitter could change. In fact, the credit channel is more relevant in emerging or developing countries which are characterised by poor financial systems, and as the economy develops, the monetary channel takes a more preeminent role in the transmission of Monetary policy. 22 There is increased attention devoted to the credit channel as it has generated a strand of literature which has extensively focused on the interplay between monetary policy and financial intermediaries. 21 Radcliff Committee, Report of the Committee on the working of the Monetary System of the Exchequer, Kamin S, P Turner and J Vant Dack (1998), "The Transmission Mechanism of Monetary Policy in Emerging Market Economies; An Overview, In the Transmission of Monetary Policy in Emerging Market Economies, Bank for International Settlements Policy Papers No.3, pp

17 244 The general development of the financial system is related to the effectiveness of monetary expansions, as the medium to long-term effect of monetary policy is more intense the lower the level of financial development. The cumulative effect of monetary expansion and contraction is larger in places where the stock market is less active or volatile. When the financial sector is relatively larger with respect to the central bank, it is more likely that asymmetric effects will appear. The smaller the central bank compared to the rest of the financial sector, the longer it takes for reserve changes to be effective. Monetary policy seems to have a larger cumulative impact when the financial system is less developed. This impact, however, takes longer time to appear then in more developed financial systems. The lags in the impact of changes in monetary aggregates are larger in countries with a relatively larger central bank and in countries with less developed financial systems, it is more likely that the effect of monetary contractions is significantly different than that of monetary expansions. Countries with larger external borrowing tend to be less financially developed and have relatively larger central banks : Effectiveness of Monetary Policy in India The Reserve Bank of India Act, (1934) sets out the central bank's objectives as, "to regulate the issue of bank notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage". 24 This broad guideline makes the objectives of monetary policy clear. The New Economic Policy (NEP) of 1991 was initiated to overcome the macroeconomic crisis. The NEP included fiscal, monetary, industrial, trade sector reforms. Against this backdrop, there was a shift in the framework of monetary policy from monetary targeting to a multiple indicators approach. It was also necessary to test the effectiveness of monetary policy in ensuring stability and financial development in the economy. 23 Luis Carranza, Jose Enrique Galdon Sanchez and Javier Gomez Biscarri (2006), "Understanding the Relationship between Financial Development and Monetary Policy", Review of International Economics, 18(5), pp Reserve Bank of India (RBI), Economic Review, Various Issues.

18 245 The data on variables like Wholesale Price Index, Net Bank Credit to the Government, Net Foreign Assets of the Banking Sector are used as the monetary policy variables and Financial Development Index constructed in the sixth chapter is used to represent financial development in India. The Wholesale Price Index in India has a large coverage of commodities and has high frequency release of data unlike the Consume Index in India. WPI is a widely used price index in India by both analysts and policy makers to examine price trends and is generally considered as an indicator of inflation in the economy. Therefore, WPI is used as an index of domestic prices. The Net Bank Credit to the government is the sum of Net RBI credit to the centre, Net RBI credit to the state governments and other banks' credit to the government. It is the credit side indicator of the monetary policy. The Net Foreign Assets of the banking sector refers to the sum of RBI's Net foreign assets and other banks' foreign exchange assets. This has propelled the growth of reserve money and is a reflection of the strong build-up of foreign exchange reserves, arising from improvements in the current and capital accounts of the balance of payments.

19 246 Table-7.3: Select Indicators of Financial Development and Monetary Policy in India Year Financial Development Index* Net Bank Credit to the Government** Wholesale Price Index Net Foreign Assets of the Banking Sector** * Compiled from Chapter 6 of the thesis. ** Amount in crores Source: Reserve Bank of India, Handbook of Statistics on Indian Economy, In order to demonstrate the effectiveness of Monetary Policy in India, we use the following regression model FDIt = β0+β1 NBC + β2wpi + β3 NFA +ut... (1) Where FDIt - is constructed Financial Development Index NBC - Net Banking Credit to the Government WPI - Wholesale Price Index NFA - Net Foreign Exchange Assets of Banks β0 - Intercept β1, β2, β3, - are the slope coefficients ut - is the stochastic error term.

20 247 The data on WPI was based on different periods and it was shifted to the single base year ( ) by using the technique of splicing. Splicing is a technique in statistics used to shift the base of a particular date from one year to another to give it a meaningful presence. The results of the multiple regression model are presented in Table-7.2 Table-7.4: Results of Multiple Regression Analysis Coefficient Standard Error P-Value R-squared β 0 (intercept) NBC 4.20E NFA E WPI -1.40E E The coefficient β0 is the intercept which means that at the beginning of the time period the financial development in the economy would be 133 per cent. As per the results, Net Bank credit is positive but statistically insignificant and Net Foreign Exchange Assets of the banks is significant at 5% level, this was theoretically expected of the variable and marginally (0.0010) influencing the financial development in India. The Coefficient value of WPI is negative and insignificant which implies that a unit increase in inflation has a negative impact on financial development in the Indian economy. The R-squared is 0.60 which means that 60 per cent of the variations in the financial development index are explained by the explanatory variables. Indian economy since 1991 has witnessed tremendous changes in the financial and monetary sector. This is an account of the initiation of the Liberalisation Policy. The measures of reforms are very broad, impacting different aspects of the financial sector. The Table-7.4 briefly describes the changes that occurred in the Indian economy on account of the financial and monetary policy reforms. The analysis of monetary policy in India has shown that monetary policy undoubtedly is an important part of public policy. The objectives and targets of monetary policy, if followed and met will have a huge impact on economic stability. Monetary policy formulation and implementation is an ever evolving process both in response to and as a consequence of changes in the financial system and the real

21 248 economy. But, monetary policy in India has become increasingly transparent with greater involvement of all the stakeholders for better policy outcome. The monetary policy in India has seen a shift from quantitative intermediate targets to interest rates, as the development of financial markets enabled transmission of policy signals through the interest rate channel. At the same time, as seen, the availability of multiple instruments such as CRR, OMO including LAF and MSS has provided necessary flexibility to monetary operations. Monetary policy formulation has become more consultative and participative with the involvement of market participants, academics and experts. The internal process has also been re-engineered with more technical analysis and market orientation. In order to enhance transparency in communication the focus has been on dissemination of information and analysis to the public through the RBI governor s monetary policy statements and also through regular sharing of policy research and macroeconomic and financial information. Historically, the general development of the financial system is related to the effectiveness of monetary policy. The effectiveness of monetary policy in relation to the financial development was tested with the help of regression analysis. The Net Bank Credit to the Government, Wholesale Price Index, Net Foreign Exchange Assets of the Banking sector are used as monetary policy variables and Financial Development Index constructed in the sixth chapter was used as an indicator of financial development. And it was found that net bank credit and net foreign exchange assets though positive were insignificant, the coefficient of wholesale price index was negative and significant by implying that a unit increase in WPI will have a negative impact on the financial development. This has been theoretically confirmed. Monetary policy governs the working and functions of financial system in India. Financial broadening and financial deepening which has occurred in the Indian economy since 1990s has enhanced the role of monetary policy and in a way monetary policy gets recognition and an implementation platform only through the various components of the financial system.